The misleading metrics of microcredit

Microcredit, often viewed as vital for low-income groups, is experiencing financial and social sustainability problems. Is the preference for and dominance of financial metrics over social metrics eroding instead of underpinning the sustainability of the industry?

Microcredit – the distribution of small loans to low-income sections of society — is one of the more fashionable tools to appear on the international development scene in recent years. It featured in the G8 summit, Toronto 2004; and 2005 was even the ‘Year of Microcredit’.

Although existing blogs cover these and other controversies, this blog attempts to highlight how some performance metrics — used to measure the ‘health’ of the industry — achieve little in the way of transparency, concealing social and financial issues to the detriment of sustainable development and sustainable markets. An example of this is the much publicised ‘repayment rate’ indicator — typically defined as repayments made against the amount owed.

Do high repayment rates equal successful markets?

Frequently one hears of microcredit repayment rates of 95 per cent, easily surpassing those found in traditional credit markets. Poverty reduction is often assumed to occur as a result of access to microcredit services, with clients using credit for microenterprises and making sufficient returns to pay loans back. High repayment rates are taken to indicate reduced poverty, with these repayment rates being fundamental to the success of microfinance. What’s more, since profit is generated by the MFI on the loan, this is presumed to indicate a financially if not socially sustainable market.

This indicator is, however, misleading; not least because clients are proven to frequently use credit to buy medicine, food or other essential purchases rather than to create or invest in microenterprises. Although not necessarily bad, the fact that credit isn’t always used for income generation leads to the possibility of debt accumulation. Alarmingly, clients are known to use repeat loans or loans from other MFIs to pay off existing loans, creating a downward spiral of ever-increasing debt. This future risk is not captured by the repayment rate, creating a false impression of financial sustainability. Perhaps the signs were always there; a 2003 Microbanking Bulletin study found that only 66 out of 124 MFIs were financially sustainable.

When ‘sustainability’ is expanded to include social issues, we find even more striking issues being hidden. Some households in Bolivia have been diverting food budgets to meet repayments. Some clients in India have been forced to repay loans under duress via the selling or seizure of personal possessions, the threat of or actual imprisonment, the forced signing of blank cheques or public shaming, and some women have resorted to prostitution in order to repay debts. Pressure is applied either by group members, credit officers, police or ‘hired hands’. The inability to repay and live with the consequences of default has contributed to growing suicide rates.

Why a focus on financial/institutional metrics?

The beginnings of the modern microfinance sector was beset with financial unsustainability, with 1960s and 1970s state-run rural credit programmes suffering from high default rates. Today the major MFIs are run commercially, with institutional success determined by movements towards financial self-sufficiency. This in turn necessitates financial metrics.

In fact of all the metrics listed on mixmarket.org — the main resource for MFI data — none directly, if at all, indicate social performance or attempt to measure impacts on poverty. Similarly, although most MFIs in India produce annual reports in addition to financial reports, few, if any, produce sustainability reports, which would focus solely on documenting their social and environmental impact. This is at the very least strange for an industry that frequently promotes its mission as poverty reduction.

The welfarist school of microfinance places greater emphasis on poverty alleviation, arguing the need to measure institutional performance by recording impacts in terms of changes in borrower welfare. Production of sustainability reports, whether voluntary or mandatory, might be able to achieve this and redress the balance in microfinance performance evaluation.

Sustainability reporting is not offered as a panacea for the issues raised, but the act of reporting should improve transparency – seen as a vital ingredient for empowerment, accountability and good governance – of the microcredit industry, and contribute to improved sustainable development outcomes and markets.